Economic Insights - January 1 - 5, 2018

Rollin’, rollin’, rollin’: The theme from the original television series Rawhide in 1959 is appropriate for the world economic expansion that itself just keeps rollin’, rollin’, rollin’.

A flatter yield curve, does it matter? Yes, it does. But it is likely suggesting the U.S. economic expansion is maturing, not that a recession is around the corner.

Rollin’, rollin’, rollin’

That’s the theme from the original television series Rawhide, which gave actor Clint Eastwood his start in Hollywood in January 1959. In the mid-19th century, cattle were herded sometimes for many miles to a train station or a market to be sold, by cowboys on horseback. The cattle were often called “doggies.”

“Rollin’, rollin’, rollin’,
Though the streams are swollen
Keep them doggies movin’, rawhide.”

That could also be the theme of the world expansion that just keeps rollin’. The pall, cast by the financial crisis, that kept businesses and consumers in the dark, worried about relapse, extra cautious about spending, and focused on cost control and job security, respectively, has lifted. Raising that cloud brought a robust, synchronized economic expansion that is widespread around the world; it is still gathering strength and keeps “them economic doggies movin’” right along.

The Eurozone economy just keeps getting better and better. The European Central Bank’s (ECB) extraordinary monetary policy of large-scale bond purchases has kept Eurozone interest rates ultra-low, lessened default risk, and allowed the economy to come back from the brink of deflation. Revisions to second-and third-quarter data pushed GDP growth to an annualized 2.9% for two quarters. Surveys of Eurozone manufacturing purchasing managers hit a record high of 60.6; the composite index edged up to the best in seven years. Germany is booming; numbers of unemployed workers keep falling; the jobless rate is 5.6%, the lowest since 1981. German business confidence is the highest in 50 years; French business confidence hit a 17-year high. Business surveys suggest economic growth could be over 3.0%.

U.S. businesses and consumers have shrugged off the malaise from the financial crisis and are powering the economy ahead. Recent U.S. data is excellent. Light-vehicle sales are resilient at a 17.8 million unit annual pace in December. Surveys of manufacturers indicate that new orders are strong; activity is robust. Initial claims for unemployment compensation as a percent of the workforce remain the lowest in decades. The trade deficit shows record imports, a sign of vigorous activity.

U.S. job growth:

December payrolls showed a smaller-than-expected number of new jobs at 148,000, but it was still a good report overall. Smaller payrolls in the retail sector were the cause of the disappointment; but, retail payrolls are notoriously hard to estimate during the holidays. Besides, 62.4% of all job categories had an increase in payrolls, a healthy sign and another reason suggesting job gains will be revised higher.

The job market remains tight. The unemployment rate was flat at 4.1%, but that’s the lowest since 2001. The unemployment rate of African-Americans hit the lowest in history. The participation rate for prime-age workers, those 25 to 54 years of age, keeps rising as many come into the workforce. Average hourly earnings rose 0.34% in the month, a solid rise; I expect wage growth to come close to 3.0% sometime in 2018, probably in the first half. With inflation still quite low, that means vigorous growth in real incomes. The U.S. labor market is very healthy.

A flatter yield curve; does it matter?

It surely does, at least eventually, but probably not yet. Over the last 12 months, the U.S. Treasury yield curve, measured as 10-year yields minus two-year yields, narrowed from 1.25% to 0.52% at the end of 2017. It occurred largely from a rise in the two-year yield from 1.20% to 1.88%; the spread narrowed further as two-year yields nearly hit 2.0% the first week of January, while 10-year yields stayed about flat from 2.35% to 2.45%.

Yes, it matters:

A flatter yield curve means that yields on longer-term U.S. Treasury bonds are not much higher than yields on short-term Treasury bonds. If the yield curve keeps getting flatter, it might invert, i.e., short rates become higher than long rates. Historically, that has been a signal that a recession was on the way in a year or so. So, the flatter the curve gets, the more investors worry about a possible inverted curve and the associated signs of recession.

Is the concern legitimate?

Maybe not yet. Yields have risen on short-term bonds because the Fed raised the fed funds rate three times in 2017 and investors expect the Fed to hike rates two more times in 2018. The Federal Open Market Committee (FOMC) is raising rates because members are upbeat and optimistic about the U.S. economic outlook and want to move policy to neutral. That was the essence of the discussion in the minutes of the December FOMC meeting. Members also thought the risks were balanced, but that “inflation developments should be monitored closely.” The Committee raised the fed funds target range by 0.25% to 1.25%, and then to 1.5%, with two members wanting to leave rates unchanged.

While short rates have risen alongside Fed rate hikes and expectations of more, those rate hikes happened in a context of years of very low reported inflation, expectations that the low inflation will persist, large bond purchases by the ECB and the Bank of Japan (BOJ), and ultra-low yields on European and Japanese government bonds. In sum, there is upward pressure on short rates from the Fed trying to push monetary policy toward normal, yet down pressure on long-term U.S. yields from persistent low inflation and financial repression from other central banks. So, the yield curve gets flatter and flatter as short rates rise and long rates don’t move.

A yield curve that gets flatter as the Fed hikes interest rates and the economic expansion gets longer is a very natural phenomenon. It has happened in the latter part of every expansion since the 1950s. While an inverted yield curve has foretold every recession since the 1950s, the risk of recession seems to come once the curve has inverted rather than from a curve that simply flattens. So, the flatter yield curve of the last several months is simply telling us that the economic expansion is mature, but, not necessarily at an end.

Could the curve steepen?

Yes, at least somewhat. It would surely happen if inflation began to work higher as we expect it over the next few months in the United States, the Eurozone, and Japan. If it does, long-term government bond yields in Europe and Japan would rise as the ECB and the BOJ lessen their extreme monetary ease. The ECB is already cutting its bond purchases in half this month and will end them by October. The BOJ will likely raise its target for 10-year bond yields above zero perhaps by mid-year.

Further, world growth is robust and on a tear; stock markets are screaming higher; yet, long-term interest rates stay at Depression-era lows. Yields as low as the current 2.45% on 10-year U.S. Treasurys are completely inconsistent with real growth rates of 3.0%. Such low yields suggest investors expect growth to slow substantially soon, a very unlikely event. In addition, yields on 10-year inflation-protected U.S. Treasury bonds suggest that investors expect inflation to be a bit above 2.0% over the next 10 years, so an extra 0.45% yield on regular 10-year bonds is not much of a cushion.

A flatter yield curve conveys information, but, but it doesn’t imply an impending recession, at least not yet. We expect the curve to steepen a bit or at least not get much flatter over the next few months. Any recession is still a year or more away.

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